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Is Disputed Partnership Income Taxable?

he claim of right doctrine requires taxpayers who
receive disputed income to treat it as taxable income if there are no
restrictions on how they can use this money. When there are
restrictions—as when the disputed money is in an escrow account—they
pay taxes on the disputed amount only when and if they receive the
money.

In 1993 Timothy Burke, an attorney and CPA, joined a partnership. In
1996 the partners orally agreed to a new method for dividing
partnership income for the years 1996–1998. In 1998 Burke’s partner
denied he had consented to the new arrangement. Later that year, the
two partners agreed to place all partnership profits (after expenses)
into an escrow account until they resolved their differences.

The partnership return for 1998 showed $242,000 of partnership
profits; $121,000 appeared on Burke’s schedule K-1. Since he was
unable to use the money, Burke did not report it on his individual tax
return. The IRS made a deficiency assessment of $41,338. Burke
petitioned the Tax Court for relief.

Result . For the IRS. Burke referred to IRC
section 703(a), which requires a partnership’s taxable income to be
computed in the same manner as an individual’s taxable income, and
cited a series of cases in which individuals did not have to report
taxable income that had restrictions on the money’s use. He argued
that he did not have to report the income until resolution of the
dispute because the partnership had deposited the money in an escrow
account, which restricted his use of it.

The court disagreed, stating that IRC section 703(a) merely
described how a partnership calculates its taxable income before
dividing that amount among the partners. Regulations section
1.702-1(a) specifically states that partners must report their
individual distributive shares of partnership income even when the
amount is not distributed. The court cited a series of cases in which
a partner had to report his or her distributive share in the year the
partnership reported the income even though the parties contested the
amount of each partner’s share. The court further stated that the
cases cited by the taxpayer did not apply since none of them involved
a partnership or its distributive shares.

It is important to note how the court applied the claim of right
doctrine. The partnership had unrestricted use of the receipts—the
partners only disputed the division of the money. If the partnership
had placed the receipts in an escrow account as the result of a
dispute with a third party, under the claim of right doctrine the
receipts would not be included in its income until the matter was
settled and the partners would need to report income only if the
dispute was settled in its favor. In this case, however, “there was
nothing conditional or contingent about” the partnership’s income, and
therefore each partner had to report his or her distributive share of
that income, even though the partnership contested the exact amount of
that distributive share.

Timothy Burke v. Commissioner, TC Memo
2005-297.

Prepared by Charles J. Reichert, CPA, professor of
accounting, University of Wisconsin, Superior.